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Musings: The New Tax Law and Governor Brown

Rick Roeder January 2018

The 2017
“accomplishment” of the Trump Administration was to pass
the most wide-ranging tax bill since 1986. The merits of the tax
bill have been highly debated. Some think tanks believe that the
bill will add long-term debt to government coffers: To the tune of
an estimated trillion or so. Others have criticized that the tax
cuts for individuals are temporary whereas the corporate tax rates
are permanent. One potential benefit of the bill is the repatriation
of corporate monies stashed abroad due to lower corporate rates. Top
corporate rates plummeted from 35% to 21%.

Republicans were
clearly aware that states with pricey real estate such as California,
New York and Massachusetts are bastions of Democrat voters. How can
you tell? Let us count the ways. First, the maximum deduction
for interest on new purchases is now based on a mortgage
ceiling of $750,000 instead of the previous ceiling of $1,000,000.
The cutback proved to be less severe than the initial House of
Representatives bill which would have slashed the mortgage cap to
$500,000. If you live in Kansas or Mississippi, such reduction is
almost never relevant. However, when a non-descript starter home in
San Mateo is now on the market for over a million dollars, the
significant loss of the interest deduction will be a potential issue
for expensive housing markets. (Editor’s note: Given Tom
Brady’s latest comeback victory and his prep career at San
Mateo’s Junipero Serra, the author felt compelled to use a San
Mateo example). Interest deductions on home equity loans have
been eliminated. Will these changes be enough to slow down the
raging California real estate market? We’ll see.

Valuable real estate
was impacted in a third way. State and local property tax
deductions are limited to $10,000, another shot at the two Coasts.
Four million taxpayers are estimated to be impacted by this change.
However, there is some compensating relief for certain high income
earners. One of the underreported aspects of the new tax law are two
significant changes to the alternative minimum tax (“AMT”).
This will help reduce or eliminate the AMT impact for the 4.4 million
impacted by the AMT before the tax bill. Most impacted by the AMT
are in the $200,000-$500,000 earning range. The AMT income
exemptions have markedly increased by roughly 30%. For married
households, the AMT income exemption has increased from $84,500 to
$104,900. In addition, the income thresholds at which the dollar
exemption starts to phase out has increased. We note that if either
political party was truly interested in tax simplification, the AMT
would be one of the first elements to be eliminated. We do know that
the AMT calculations alone would be difficult to put on a post card.

The top individual tax
rate was only slightly reduced from 39.6% to 37%. Donald Trump
railed against a “carried interest” loophole in his
Presidential campaign. This allows a hedge fund manager to be
compensated from a fund on a basis that earnings are capital gains
instead of ordinary income. Given that the capital gains rate is
currently 23.8%, this represented a significant tax break for Wall
Street. Over Trump’s objections, carried interest remains
alive and well, although the minimum asset holding period was
lengthened to 3 years.

So, was Trump a loser
in the tax bill? Au contraire, those in the commercial real estate
business may have been the biggest winners. Not only was the
depreciation period on buildings significantly shortened to 25 years,
the cap on immediate expensing of certain improvements (as opposed to
establishing a new depreciation base) was doubled from $500,000 to
$1,000,000.

When 1986’s
sweeping tax changes passed, a significant tax credit was created for
construction of affordable housing for low income families. The
credit proved so successful as to evolve into a $9 billion/year
social program. However, with the lowering of corporate tax rates,
the credit becomes less tax effective. Some feel that the lower
corporate rates will put a big dent in the creation of added
low-income housing. America has already seen an unfortunate
explosion in homelessness. If the projections come true that the
growth of subsidized housing will be reduced by 225,000 units over
the next decade, an undesired and unintended byproduct of lowered
corporate tax rates will occur.

There are a number of
subtle changes to the law which will have impact not capable of
immediate measurement. For example, one item came to the attention
to yours truly, having written a book on college football history
(College Football Odyssey is an ebook in its 2nd
edition on Amazon). High profile college football programs are
upset about the change in treatment of personal seat licenses. For
numerous teams that have a high demand for season tickets, buying a
season ticket is not a straight forward process. To have such
“privilege”, buying a personal seat license can be a
prerequisite. In some cases, this license is so pricey that it makes
the face value of the tickets look like comparative chump change.
Prior to the tax law change, 80% of the personal seat license was
deductible. Eliminated! We imagine there will be a number of such
areas of unintended impact.

Back in California, a
political living legend, Jerry Brown, has embraced the Kris
Kristofferson lyric, “Freedom is another word for nothing
left to lose.,” Skyrocketing pension costs have been
crippling the ability of many entities’ ongoing ability to
provide basic services. When Brown led the march for the state
legislature to pass “PEPRA” in 2012, benefits were
significantly lowered for post- January 1, 2013 hires. What was the
immediate effect on skyrocketing pension contributions for affected
California entities. Nada. Since the changes were limited to new
hires, the impact would only be gradual, not Brown’s desired,
immediate antidote. Why not do something more immediate, one might
ask: Because the legislature’s hands were tied. Under the
“California Rule, “ established in the 1950’s, the
vesting rules protect just not the higher benefits associated with
past service but also with potential future service. Thus, if you
were hired in December 2012, you are grandfathered in a higher
benefit formula even if your retirement date does not occur until
2050. In the private sector, no comparable law has ever existed
which protects potential prospective benefits. Even with PEPRA’s
passage, the state’s two gargantuan pension plans, CalPERS and
CalSTRS, currently have a combined unfunded liability of $250+
billion. Many of the state’s 35 other independent retirement
systems and the local CalPERS contracting agencies face similar
funding challenges.

Brown’s
willingness to take actions frowned upon by numerous unions were
steps most Democrats would not dare to do. In addition to the
benefit cutbacks for post-2012 hires, the PEPRA bill contained some
“take aways’ for otherwise grandfathered employees.
Certain safety employees were forced to make additional employee
contributions. Definitions of allowable pension pay were tightened
in an effort to curtail the “spiking” of pay during a
member’s final average compensation period. Employees were no
longer allowed to purchase additional years of service (aka “air
time”). Various unions filed lawsuits in regard to such “take
aways,” taking the reasonable position that there was no
compensating added benefit that would satisfy the provisions of the
California Rule. The application of the California Rule will be
critical in the state Supreme Court’s coming decisions.

Jerry Brown, a
Democrat in one of the few states where labor still retains very
strong clout, has minced no words in taking on the California Rule,
opining that pension costs should not be so high as to compromise
other essential services. Brown’s stance may be influenced by
the reality that the spunky 79-year-old will not be running for any
more political offices. To date, Brown has been successful in
getting favorable rulings from the lower courts in overturning the
California Rule in these fact situations. The Supreme Court’s
coming ruling will undoubtedly reverberate with numerous other states
with similar laws. Stay tuned.

Jerry Brown has often
defied orthodox stereotypes the public imposes on a politician.
Shortly after Brown became the one of the youngest Governors in
California’s history in 1975, he received notoriety for being
in a high-profile relationship with singing diva, Linda Ronstadt.
(Remember that dating a pop star defied the political norms of
that period. Such time was well before the Clinton and Trump White
Houses shattered those norms). Despite such notoriety, Brown
developed a reputation for his frugality, in contrast to the
stereotype that Democrats, legislatively, tend to be bigger spenders
than their Republican brethren. Most folks approaching their 80th
birthday are content to go quietly into the night. Not Brown. He
has been the anti-Trump in terms of attempting to aggressively deal
with global warming and embracing California as a state of
“sanctuary.” In 2017, California sued the Trump
administration no less than 17 times. The Sacramento-Trump war is
not abating in 2018 as legislators are taking clear aim at Trump’s
attempts to overturn “net neutrality.”

Brown is openly
scornful of the new tax law, labeling the bill as an “assault
by Congress on California.” Being the son of a governor, Pat,
who beat a guy named Richard Nixon in the 1962 gubernatorial race,
Jerry had a lot to live up to. By most accounts, he clearly has done
so.

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